Dividend Alternatives: 101

Given the tremendous volatility in today’s markets, brought on by uncertainty in economic conditions and geopolitical tensions, many people look to dividend-paying securities for a portion of their portfolio. As with all things in life, these instruments come in many flavors—each with a degree of risk—so it’s important to be familiar with some of the basic concepts.

ALL ABOUT BOND RATINGS

One of the proven methods used to help manage risk when purchasing dividendpaying securities is to research their ratings. Neither infallible nor permanent, these objective evaluations appraise the current financial stability of issuers. They are prepared by independent rating agencies, and can serve as a guide for investors and their financial advisors.

The principal rating agencies are Moody’s Investor Service and Standard & Poor’s (S&P). After their analysts assess a number of factors, they assign a letter rating to each issue. Under the Moody’s system, investment grade bonds, that is, issues that may be suitable for purchase by conservative investors, are rated Aaa, Aa, A, and Baa. S&P rates this same category as AAA, AA, A, and BBB.

An issue rated Aaa by Moody’s is comparable to one rated AAA (“triple A”) by S&P. In both cases, bonds carrying these respective ratings are judged to be of the highest quality, with the smallest degree of credit risk. As a result, issuers of these bonds can generally offer the lowest interest rates that the market can bear.

The lowest rating for the Moody’s scale is C, a warning to investors that the issuer’s chances of meeting its obligations may be poor. S&P’s bottom rating is D, which indicates that the issue is in default, with interest or repayment of principal in arrears.

Most major investment firms’ research reports include the current ratings, from at least one agency, for some of the fixed income instruments we will discuss. It is important, given today’s uncertainty, and how fast we’ve seen corporate balance sheets evaporate, to keep current on ratings changes that occur. Note any downward revisions in securities you own as a wake-up call to review the holding and determine whether the reward of holding the investment is worth the increased risk.

Here are some different dividendpaying securities that may add some precious income to your portfolio.

PREFERRED SECURITIES

These hybrids of stock and bond are a great solution for some investors, because they can be bought and sold, and they provide a fixed payment.

Like common stocks, preferred securities represent equity in a company and are often listed on the New York Stock Exchange, making it easy for investors to monitor and sell. Preferreds also share many of the characteristics of bonds. Most pay a relatively high quarterly rate that is fixed at the time of issue.

Preferreds are interest rate sensitive and often have call features, which allow the issuer to redeem the stock by paying the investor a stated premium price for the shares on a specified date. If the interest rates decline, the price may rise, in which case the issuer may opt to redeem the securities and issue new ones at a lower rate. However, if interest rates remain the same, the company is not likely to call them preferred securities.

The reason they are called “preferred” is that the payments made on these securities have preference over, or are senior to, common stocks. In other words, payments must be made to preferred securities holders before dividends can be paid to common stock owners. Cumulative preferred securities require all missed payments to be made up before any dividends on any common stock are paid. In addition, common stock dividends must be suspended before any preferred securities can be suspended. However, preferred securities are considered subordinate to bonds; also, they do not generally come with voting rights.

Some of the newer preferred securities that are of particular interest to individual investors include:

Monthly Income Preferred Securities (MIPS):

MIPS represent a special purpose company that is created for the sole purpose of issuing preferred securities and lending the proceeds back to the parent company. MIPS are structured to make monthly payments.

Monthly Income Debt Securities (MIDS):

These subordinated debentures are issued directly to investors by the parent/ operating company and make monthly payments. They usually have 30-50-year stated maturities.

Quarterly Income Debt Securities (QUIDS):

These are also subordinated debentures that are issued directly to investors by the parent/operating company and make quarterly payments. They usually have 30-50-year stated maturities.

Trust Originated Preferred Securities (TOPrS):

TOPrS are issued by a special purpose business grantor trust that exists only to issue preferred securities and then lend the net sale proceeds to the parent company by purchasing a long-term debenture. Payments are made quarterly. They are not direct obligations of the parent company, although the parent company does guarantee the payments.

American Depository Shares (ADS):

ADS are a type of traditional preferred security. They are issued by international corporations, mostly banks, that are trying to access the US capital markets. There is no currency conversion risk because they are issued in US dollars; however, these securities are subject to other risks associated with foreign investing, such as social and political changes.

CONVERTIBLE BONDS

In this uncertain economic environment, many investors want to have their cake and eat it too. They’d like to have the potential for capital gains found in stocks, along with the interest income from a bond. Investors may find a measure of both in convertible bonds. As the name suggests, a convertible bond is a debt obligation that pays a fixed interest rate like a bond, but can be converted into common stock shares in the issuing company.

Investors can potentially earn money with convertibles in several ways. First, the bonds pay income to investors at a fixed rate, like a traditional bond. Second, the convertibles can appreciate in value, and may result in a gain when the investor sells the bonds. Finally, the bonds can be converted into stock, if the price has increased enough to justify conversion, and sold for a gain. Of course, convertible bonds also possess the potential that their price will decline. Investors pay a premium for this flexibility, because convertible bonds typically yield more than common stock. Also, convertible bonds offer comparatively less security than straight bonds because their price is more volatile, as their value is roughly linked to the price of the common stock. However, the price of the convertible usually will not drop as rapidly as the stock, thus providing some protection.

The three key factors to understand when considering convertible bonds are conversion premium, premium recovery, and call features. The conversion premium simply is the difference between the cost of the bonds and the value of the equivalent stock into which the bonds can be converted. Typically, a convertible will sell for a premium of 25%-30% more than the underlying common stock. The higher the premium, the longer it will take for the bond to reach the value of the stock, but a low premium should not be used as the sole criteria in evaluating a convertible bond.

The calculation of how long it will take the investor to recover the premium paid for the convertible bond is called premium recovery or break-even time. It usually averages two to three years. Investors should understand what the premium recovery period is before they invest, as it has a direct effect on the flexibility of their investment.

Finally, when investing in convertibles, it is essential to know the call features, or, when the issuing company can redeem the bonds for common stock or cash. A call can be made even when the price is below the market value of the stock or the bond’s conversion value. Most convertible bonds have “call protection” for a minimum of two years from the date of their initial issuance.

REAL ESTATE INVESTMENT TRUSTS (REIT)

A REIT can help diversify your portfolio, offer steady current income, and provide a hedge against inflation. But what exactly is a REIT? If you’re like most investors, you may not be familiar with REITs and the relative advantages they might provide for your portfolio.

Origins of the REIT

The origins of the REIT (pronounced “reet”) date back to the 1880s. Investors in REITs at that time could eliminate double taxation because trusts were not taxed at the corporate level if income was distributed to beneficiaries. This tax advantage was later reversed in the 1930s. After WWII, the demand for real estate skyrocketed; in 1960 a real estate investment trust tax provision was enacted, which established special tax considerations qualifying REITs as pass through entities eliminating the double taxation of dividends. This legislation provided small investors with the opportunity to participate in the investment returns from large-scale, income-producing real estate. Tax reform legislation passed in 1986 and 1993 eliminated the use of REITs as tax shelters, and new REIT offerings were structured to meet the needs of individual investors.

Today’s REITs are publicly traded companies that own and manage income-producing real estate, such as office buildings, hotels, retail malls, or apartment buildings. There are three types of REITs: equity, mortgage, and hybrid. Equity REITs invest in and own properties and represent the vast majority of all REITs. Shares of REITs are primarily traded on major stock exchanges, which makes them highly liquid and easier to buy and sell than it would be to buy or sell real estate through direct ownership. REITs typically have no minimum or a very low minimum initial investment that allows individuals to invest in a professionally managed portfolio of real estate properties through mutual funds.

Benefits of REIT

One of the most attractive features of REITs is that most do not pay corporate income tax to the Internal Revenue Service. Additionally, most states honor this treatment and do not require REITs to pay state income tax. This enables a REIT to pass most of its income on to investors in the form of dividends. In fact, as of 2001 the law specifies that REITs must pass at least 90% of their taxable income on to shareholders in the form of dividends.

As investments, REITs pay among the highest dividends. Between 1995 and 2000, the average dividend yield on REITs was 7.3% — significantly higher than yields of most stocks paying dividends. These dividends come primarily from the relatively stable and predictable stream of contractual rents paid by the tenants that occupy REIT’s properties. And, unlike interest payments on bonds, rental rates tend to rise during periods of inflation. Thus, the dividends from REIT stocks are protected to a degree from the long-term corrosive effects of inflation and rising prices.

According to Ibbotson Associates, REIT stocks registered a compound annual return of 12.4% from 1981 to 2000 compared to 12% for government bonds, 13.3% for Ibbotson’s Small Stock Index, and 15.7% for the S&P 500. Past performance is no guarantee of future results.

In addition to their potential to provide relatively high current income and moderate capital appreciation, REITs represent a strong source of diversification for a wide range of investment portfolios. Research done by Ibbotson and Associates demonstrated a low correlation of REIT returns with those of other equities and long-term bonds. This makes the case for inclusion of REITs in investment portfolios as a hedge against the volatility and underperformance of other securities. Over the long haul, REITs offer the benefits of diversification by boosting returns and reducing risks.

If you decide to add REITs to your portfolio, be discriminating. There are special risks associated with an investment in real estate, including credit risk, interest rate fluctuations, and the impact of varied economic conditions. You should apply the same careful analysis in purchasing a REIT that you would to any other financial investment.

CONCLUSION

I hope this provides a little background information on a few of the different dividend- paying instruments. Your trusted professional financial advisor is the best source for advice and feedback when considering these opportunities. The investment vehicles described throughout this article may not be suitable for all investors. As always, remember that past performance is not indicative of future results.